Delta’s Refinery Plan Could Be Game-Changing

Delta Air Lines' decision to acquire an oil refinery near Philadelphia—a purchase without precedent in the airline industry—is meeting with much skepticism. But Delta's competitors must also ask themselves, “What if the plan works?”

Atlanta-based Delta estimates the purchase of the refinery by its newly created Monroe Energy subsidiary will save it $300 million a year in jet fuel costs. Those savings will not come on the price of crude: Delta, like other airlines, will continue to use financial instruments to hedge on the cost of crude to protect against oil price increases and volatility.

But the crack spread—the gap in price between crude and the refined jet fuel product—is not conducive to hedging. That spread has increased dramatically in recent years, which is why Delta says it seized the opportunity to acquire the Trainer, Pa., refinery at what it considers a bargain price. The jet crack spread accounted for $2.2 billion of Delta's $12 billion fuel bill in 2011 and 10% of its total unit costs, up from 3% in 2009.

Delta is spending $150 million to purchase the refinery from Phillips 66, net of $30 million in support from the state of Pennsylvania, with the deal expected to close by July and jet fuel production to begin during the third quarter. It will spend another $100 million to upgrade the refinery by the end of September in an attempt to more than double its jet-fuel production to 32% of the output.

That jet fuel will be transported to supply its aircraft in the Northeast, including its growing hubs at New York's John F. Kennedy International and LaGuardia airports. The non-jet-fuel output—diesel, gasoline and other products—will be traded on a one-to-one basis for jet fuel near Delta operations in other parts of the country via multi-year deals with BP and Phillips 66.

Altogether, Delta says the direct output and exchanges will cover 80% of its domestic jet-fuel needs.

There are risks for Delta, of course, but if the plan works, it could be a game-changer.

Philip Verleger, Jr., a consultant on energy and commodity markets who publishes Petroleum Economics Monthly, says owning the oil refinery could give Delta a fuel-cost advantage of at least 20 cents a gallon over competitors on transatlantic services from New York.

Just reducing the refining margin on jet fuel will provide much of Delta's savings, because the crack spread now stands at about 15 cents a gallon, according to Verleger. Another 5-10 cents per gallon in savings will come from the reduced supply of jet fuel on the East Coast for Delta's competitors in the New York market and their growing reliance on more expensive imported stocks, he says.

These benefits alone could give Delta a $4,000-5,000 advantage on every flight from Kennedy to London Heathrow Airport, Verleger calculates, and grow even higher should the small number of refineries located on the East Coast use the supply shortage to raise prices.

“I fully expect to see five years from now that a much larger share of the international flights from JFK will be Delta's,” says Verleger. “To really build New York and make it work, you need a cost advantage, and this gives them the cost advantage.”

Verleger also foresees competitive problems for United Airlines on transatlantic services out of Newark Liberty International Airport.

According to Verleger, Delta's potential competitive advantage compares to Southwest Airlines' hedging policy before the spike in fuel costs that gave it a distinct cost advantage for several years over the many U.S. airlines that did not hedge. “By acquiring the Trainer refinery, Delta may pull off the same feat as Southwest,” Verleger says.

“Delta will be able to cover a large portion of its jet fuel needs at the major New York airports at a cost substantially below that of its competitors,” Verleger adds. “This advantage would be particularly useful in the very competitive North Atlantic market, where Delta goes up against American [Airlines], British Airways, Lufthansa, Air France, United and Virgin Atlantic, among others.

“With Trainer, Delta could match the competition's prices and pocket profits from lower-cost fuel,” he continues. “Alternatively, it could follow Southwest's example and initially pass the cost savings on to consumers. This would force larger losses on other airlines or cause them to exit the market.

“We bet that Delta chooses the latter option,” Verleger says.

American Airlines, restructuring under Chapter 11 protection, is “in no position to fight a price war,” he notes, and could be particularly vulnerable on its New York-London route. British Airways, which has a joint venture with American on transatlantic services, could also pay a price. Air France should be insulated through its joint venture with Delta on transatlantic services.

Domestic route-savings also would be significant, but not as high because the routes are shorter. Still, any savings would help Delta, particularly in Atlanta, where Southwest will be establishing a big presence in the coming years, thanks to its acquisition of AirTran Airways.

For New York, Delta also notes that its jet fuel will be “easily transported” to tank farms near the city. That is a “significant tactical advantage,” it says, because it believes its competitors will “have to fight it out with pipeline companies to get jet fuel from the Gulf [of Mexico] or elsewhere.”

The airline adds, “we're making it right in the neighborhood and we'll capture the tariffs we currently pay to pipeline companies to move jet fuel. In that the transatlantic is brutally competitive, every single penny counts.” In other Northeast U.S. locales and with exchanges for jet fuel in other locations, Delta says its fuel transport savings will be significant across the country.

The dearth of options Delta's competitors could use to respond makes Delta's move look even better and may leave them holding out some legitimate hope that the gambit will fail. There is no precedent within the airline industry—and precious few outside it—for an end-user acquiring a refinery.

Delta is expecting its refinery to be profitable, but that is a broad assumption, given the economic difficulties affecting refineries in the past years partly due to low margins on gasoline. Delta already will be forgoing some of the potential profit by selling jet fuel to itself without the margin.

Raymond James airline analyst James Parker praises Delta for “thinking outside the barrel” and taking what he considers a “low-risk bet,” but he assumes some of Delta's estimated $300 million in savings will be offset by refinery losses. A key question will be whether Delta's expected refinery profits materialize and, if they do not, how much of its jet fuel savings will be offset by losses.

Environmental regulations also could create problems, especially if the U.S. Environmental Protection Agency tightens rules on sulfur levels in fuel, Verleger says. Boosting jet fuel production will create more sulfur, he notes.

Spending to comply with such regulations “can easily be the cost of one or two [Boeing] 777s,” adds Verleger.

Refineries also have to be shut down every year or so for maintenance and accidents often occur when refineries come back online, Verleger notes. Refinery owners usually build inventories of the refined products ahead of time to carry them through the shutdowns—or strike deals with other refiners to cover each other during their respective maintenance periods—but Delta still will face the risk of an unexpected shutdown.

Refineries also pay interest on that extra inventory, and Delta could find that cost rising in the coming years as interest rates rise.

Delta believes its risks are mitigated. For example, the airline says it has environmental indemnities for anything that occurs because of actions prior to its ownership of the refinery. It has hired Jeffrey Warmann, a 25-year industry veteran and former manager for Murphy Oil USA's Meraux, La., refinery, to run its facility, along with an experienced team.

Delta also notes that it has a three-year agreement with BP to supply the crude oil to be refined at the facility, in addition to agreements with BP and Phillips 66 to exchange the refinery's non-jet-fuel products for jet fuel supplies.

Moreover, as gasoline crack spreads fall, jet fuel crack spreads usually rise, in which case owning the refinery will generate more fuel savings for Delta, the airline says. If gasoline crack spreads rise, Delta believes it will benefit, like its competitors, from lower jet fuel prices, but it will also receive better jet fuel exchanges on its refinery's gasoline output.

Delta CEO Richard Anderson points out that acquiring the refinery and upgrading it will cost about the same as acquiring one 777 at list price. With anticipated annual savings of $300 million, Anderson says, “I actually think this is a lot less risky than buying 60 new airplanes and spending $2.5 billion in capital,” which is what Delta calculates it would need to do to achieve the same amount of cost savings by operating more fuel-efficient aircraft.